THE FICTION OF THE ‘GREAT CAPITAL REBUILD’

The central element of the Bank of England’s narrative on the UK banking system is the ‘Great Capital Rebuild’. To paraphrase Governor Carney’s comments when the 2015 stress tests were released: the post-Global Financial Crisis (GFC) period and the long march to higher capital are over. The message – which he has repeated since – is that UK banks are now more or less fully capitalised.

Unfortunately, the ‘Great Capital Rebuild’ is a fiction.

Let’s look at the evidence. Exhibit A is the following chart (Chart B.2) from the BoE’s November 2016 Financial Stability Report.

(a) Prior to 2012, data are based on the simple leverage ratio defined as the ratio of shareholders’ claims to total assets based on banks’ published accounts (note a discontinuity due to introduction of IFRS accounting standards in 2005, which tends to reduce leverage ratios thereafter). The peer group used in Chart B.1also applies here.

(b) Weighted by total exposures.

(c) The Basel III leverage ratio corresponds to aggregate peer group Tier 1 capital over aggregate leverage ratio exposure. Up to 2013, Tier 1 capital includes grandfathered capital instruments and the exposure measure is based on the Basel 2010 definition. From 2014 H1, Tier 1 capital excludes grandfathered capital instruments and the exposure measure is based on the Basel 2014 definition.

This chart shows some of the BoE’s own estimates of UK banks’ leverage ratios spanning 2001 to 2016: the leverage ratio is the ratio of some measure of capital to the total amount at risk. This chart indicates that UK banks’ leverage ratios are a little higher than a decade ago – maybe 25% on this measure, but certainly no multiple – and a decade ago the banks were on the eve of an almighty crash.

Now comparing leverage ratios before the GFC and after is a tricky business because of definitional changes made by Basel III. Yet the Bank itself publishes figures for two leverage ratios known as Simple Leverage Ratios (SLRs): the ratio of shareholder equity to total assets. One refers to the book value of shareholder equity and the other to the market value of shareholder equity. These series give average SLRs across the banking system and span the period from before the GFC until recently. [2] To the extent that we can rely on these to give us a before and after comparison, the average book value SLR was just under 4.1 percent in 2006 and 6.2 percent in the first half of 2016, representing an increase of 51 percent. [3]

The corresponding market value SLR was 8.0 percent going into 2006 and 5.28 percent in November 2015, representing a decrease of 34 percent. [4] By this latter measure, UK banks are more highly leveraged now than they were going into the crisis.

I would suggest that it would be prudent to pay attention to these market value figures: the market values being less than book values is a signal that the market perceives problems with the book values.

Then consider that the big four banks’ total Common Equity Tier 1 (CET1) capital was about £205 billion by the end of 2016q3. This figure is barely £90 billion higher than the £116 billion Tier 1 capital that they had going into 2007, although one must acknowledge that this £90 billion difference does not allow for the considerable improvement in quality between Basel II Tier I capital and Basel III CET1.

The 2016q3 £205 billion CET1 number is a book value figure, however, and the corresponding market value of its CET1 capital was about £149 billion.

We should also assess these numbers against the sizes of the banks’ balance sheets, and it is traditional to use Total Assets as such a measure. Given that their Total Assets were just under £5 trillion at the same date, their average CET1 leverage ratio (or ratio of CET1 capital to total assets) was 4.0 percent if we go by book values and just under 3 percent if we go by market values.

By the first measure, UK banks are leveraged by a factor of 1 divided by 4 percent or 25: they have £25 in assets for every £1 in capital; and by the second measure, they are leveraged by a factor of over 33. These are high levels of leverage that leave the banks vulnerable to shocks – and high levels of leverage aka inadequate capital were a key factor contributing to the severity of the GFC.

Putting all this together, the evidence for a ‘Great Capital Rebuild’ is not there – especially if one pays attention to the market value numbers.

As a further confirmation, Chart B.3 in the Bank’s November 2016 Financial Stability Report states that “Most capital rebuilding to date has reflected falls in risk-weighted assets” – a delightful piece of duckspeak – and then gives a breakdown of this ‘rebuild’ in terms of its constituent components. The rebuild it is referring to is not quite what it might seem, however: it refers to the rebuild in the banks’ average ratio of CET1 capital to risk-weighted assets (RWA) relative to 2009. Now the CET1 ratio was 6.92 percent in 2009 and had risen to 12.61 percent by end-2015. That increase breaks down into 0.45 percentage points in new equity raised, 1.02 percentage points in retained earnings and 4.22 percentage points in reductions in risk-weighted assets. Therefore, only 1.47 percentage points of that increase in the capital ratio represents actual increases in capital; the rest, the 4.22 percentage points decrease in risk-weighted assets merely reflects the decrease in the denominator. I would suggest that the chart should have stated “Most of the increase in the ratio of capital to RWAs to date has reflected falls in risk-weighted assets” but that doesn’t quite convey the same message. The increase in the capital ratio from 6.92 percent to 12.61 percent might seem impressive at first sight – an increase of 82 percent – but the actual capital rebuild was only from 6.92 percent to 8.39 percent, an increase of about 21 percent.

A big increase in a regulatory capital ratio is one thing, but a big increase in actual capital is quite another.

Let’s face it: the ‘Great Capital Rebuild’ is not there in the data.

[1] Kevin thanks Sir John Vickers for helpful inputs to this posting.
[2] These figures will overstate the leverage ratio and understate true levels of leverage because they use the larger Shareholder Equity measure rather a narrow core capital measure such as Core Tier 1 or CET1, but they give some sense of the trends over time.
[3]These figures are to be found on p. 57 of the Bank’s November 2016 Financial Stability Report.
[4] These figures come from the BoE Excel workbook ‘ccbdec15.xlsx, spreadsheet ‘9. Bank equity measures’ under the C column, ‘Market-based leverage ratio (%)’. This workbook was accessed on March 9th 20616 but appears to have been removed from the BoE website since the time I accessed and downloaded it.